Clear Eyed Capitalist

Archive for October, 2006

A month ago I asked a traditional MBA grad and experienced businessperson for his insight into what was driving the rash of hedge-fund takeovers of business. Beyond the rationale of avoiding Sarbanes-Oxley compliance he suggested 3 major reasons a company could get a profit-boost under new ownership:

1) Lever-up: increase your leverage by borrowing money. He suggested 20% of your total debt/equity float in debt seems to be a good number. Presumably you’re growing your business at a faster rate than interest rates so you can boost shareholder earnings by borrowing, running more business, servicing the debt and returning the extra to shareholders.
2) Kill-off money-losing business units that current management retains for sentimental reasons. I’ll focus on this one in a second.
3) Replace bad management

The example he gave for #2 seems to hit me right where I struggle. He referred to the Topps (sports cards, bazooka gum) proxy fight with its hedge fund investors (Pembridge Capital Management and Crescendo Partners) as an example where the hedge-funds want to come in and cut unprofitable units but management wants to restructure. To him it was a no-brainer, the units are losing money, the market demand has changed over the last 30 years, ditch it. One possible unit might be bazooka gum: a letter to investors by the “Topps Full Value Committee” –the two hedge funds- states that the gum isn’t available in warehouse clubs because their price would be below its cost to manufacture. Another possibility might be football cards – the sports card segment has been performing poorly according to a 2006 investor presentation.

So how long do we spend trying to restructure? Which unit do we cut? From a pure business perspective it’s pretty straightforward – cut what’s losing money and ta-daa, we’re profitable. Of course you looked at its contribution margin to your overhead first. And sure, pay attention to risks of angering customers who might then walk away from your remaining products, but these businesses seem separate enough that their customer segments don’t overlap.

But it’s more than a financial decision, there are social ramifications too – thousands, likely hundreds of thousands of customers will be impacted by one of these products disappearing – especially sports cards! But free market idealists say: well, if they cared that much they’d pay more. Or- well, some people care, but not enough to support our profit margin so clearly as a society that capital can be more efficiently allocated elsewhere and that’s tough – we can’t make everybody happy all the time and this is how we make those tough choices.

So, lets suppose the football card unit loses money, and management is just being sentimental and using the rest of the company to subsidize it. Perhaps it should be spun off as a non-profit business and management can subsidize it out of their own pockets instead out of the shareholders pockets. In this perspective they’re not acting in the interest of shareholders and now Pembridge and Crescendo are being forced to agitate to make them change and stop wasting shareholder money. But what about customers, suppliers and employees? Are there also more “efficient” jobs? Maybe, but not in the same neighborhood, with the same community support and the same or better income, otherwise the employees would have left already.

The problem is that capital is far more mobile than are employees, supplier relationships & delivery routes. Depending on the business (in fact, likely if they read Michael Porter!) there may not be available substitute products for customers. So the impact of reallocating that capital to be more efficient, which is supposed to be ultimately to society’s benefit, actually is more efficient for the shareholders and less efficient for the other stakeholders. That “efficiency upgrade” is really an efficiency transfer, from the accounts of the other stakeholders to the shareholders. You could argue it is a necessary one, because without it there’s an ongoing transfer from the shareholders in lost profits. How do we as a society weigh our needs to build up retirements and provide unearned income against our needs to deliver services and provide jobs?

It’s because they already have lots of capital that Pembridge and Crescendo have the ability to step to the table and enter the discussion about the future of Topps. What about everybody else? What about those other stakeholders who might value the jobs or the services? Sure there are smaller investors and they get to vote in this case because it’s a proxy fight to elect new directors and takeover from within rather than a buyout, but how do they know what they’re really voting for? In these decisions that affect many parties, only those with wealth get a meaningful voice, so unsurprisingly the result is whatever is most favorable for capital.

Most people know the basic theory of capitalism: supply and demand. They can name Adam Smith, maybe have heard of the invisible hand. But it has long frustrated me that most people seem to believe that the real world is somehow that simple. Competition will drive prices down. But wait, the theory is actually that competition will drive prices down to cost, and that’s not sustainable because then everybody goes out of business. Oops, well, there’s also “what the market will bear” so economics as the layman seems to perceive it is the intersection between two curves: “what the market will bear” and “competition drives prices down”.
MBAs however read Michael Porter, who did fundamental studies of competition in business in the 70s. Of course businesses don’t want their prices driven down by direct competition, that cuts into profits! Your goal as a business is to avoid that situation, and to help us Porter developed a model of the 5 competitive forces that pull on a company: 1) the negotiating power of your customers 2) the negotiating power of your suppliers 3) barriers to entry to new competitors 4) substitute products that effectively compete with yours and 5) your direct competitors. Wikipedia notes that some argue that a 6th force of “other stakeholders” like regulators and activists could be added, but I see this as a list of stakeholders already – stakeholders that can fight you for a piece of your profit pie.

Of these let’s draw our attention back to number 3 – barriers to entry for new competitors. New competitors are hungry and willing to give up profits to gain market share which forces you to lower your price (classic theory of capitalism!) and then they become part of number 5 – direct competitors that can take business away from you. So to keep that competitive pricing in the theory books, what businesses want to actually do in practice is choose an “Entry Deterring Price”. You don’t price your goods just below your direct competitors’ because then you have a price war, and as someone said to me recently: you win by going out of business. Instead you price your goods just below the price at which a small new competitor could enter the business. If you have a capital-intensive business like some kind of manufacturing or need expensive infrastructure to get started, then you have lots of room to price high. If you have a service business with low barriers to entry, you’ll need to lower your price to a point where someone can’t bootstrap a new business on a low volume of sales at your price.

So aha! I knew it, and now here it is in B-school cannon: competition should not drive prices down. Since Michael Porter and certainly before, direct competitors focus on differentiation: it is innovation that disrupts markets and pricing. Not all businesses are run by MBAs, so there’s still the occasional price war, but since the days I summered at 7-11 and watched Coke and Pepsi magically alternate weeks on-sale I’ve known the markets are not nearly as competitive as some anti-intervention dear friends would like to believe. Invisible hand? How ‘bout the invisible handshake?